How behavioral economics can help corporations and ...the implications of neoclassical economics and proposed alternative models in order to increase the predictive power of economic

How behavioral economics can help corporations and government agencies

kpmg.com

June 2018

Shopping with a credit card is undoubtedly convenient compared to shopping with cash. What is not so obvious is that credit cards can cause shoppers to spend more than if they used cash. Behavioral economists, such as Richard Thaler, the most recent recipient of the Nobel Prize in Economic Sciences, started explaining this and other interesting behavioral phenomenon associated with how human beings make decisions nearly two decades ago. Thaler explained how “mental accounting” drives financial decisions: Credit cards decouple the benefit of the purchase from the payment by both separating the payment from the purchase and delaying the payment.1 Casino chips (or tokens) have a similar impact on our decisions: Gambling with a piece of plastic chip that is worth $50 can be easier than gambling with a $50 bill. Similar to credit cards, casino chips decouple the activity from the ultimate financial impact.

Behavioral Economics has been combining principles from economics, psychology, and other social sciences to understand how individuals make decisions when faced with certain situations. Insights from the behavioral economics literature have been shaping strategies and policies of both companies and government agencies.

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Neoclassical (or traditional) economists explained the world by relying on a “rational” agent who optimizes economic gain or personal utility when presented with a scenario. Prominent researchers such as Markowitz (1952), Simon (1955), Strotz (1955)2 have criticized some of the implications of neoclassical economics and proposed alternative models in order to increase the predictive power of economic analysis. However, only in the late 1970s was behavioral economics born.3 In 1979, two Israeli psychologists, Daniel Kahneman (recipient of the 2002 Nobel Prize in Economics Sciences) and Amos Tversky, already famous for their work on judgment heuristics, published a paper in the journal Econometrica titled, “Prospect Theory: An Analysis of Decision under Risk.”4 This paper provided compelling evidence from actual human decisions that clearly were inconsistent with the rational agent theory.5 Other works of Daniel Kahneman have shown that humans systematically make choices that defy clear logic – also known as “irrational behavior.”6 For example, suppose that college students are deciding on which courses to take next semester, and they see a summary of evaluations from hundreds of other students indicating that a certain course is very good. Then suppose that they watch a video interview of just one student, giving a negative review of the course. Even when students were told in advance that such a negative review was atypical, research suggests that they are more influenced by the vivid negative review than the summary of hundreds of evaluations, even though such behavior seems irrational.7

Nudging

Behavioral economics research provides many interesting examples on how subtle changes in the settings in which decisions are made can alter human behavior. Richard Thaler introduced the term “nudging” that provides a roadmap for practical applications of behavioral science and psychology, specifically for business strategies and public policy making. Thaler defines a nudge as “any aspect of the choice architecture that alters people’s behavior in a predictable way, without forbidding any options or significantly changing their economic incentives.”8 In a well-known example, Netflix automatically loads the next episode or program on the screen to effectively encourage binge-watching, an example of nudging that makes the members behave in ways that are more aligned with company objectives (i.e., keep members on Netflix longer that may in return benefit enrollment). Similarly, smart phone users certainly experience how often the apps make themselves known via notifications so that the users interact with the apps!

Origins of behavioral economics

© 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name and logo are registered trademarks or trademarks of KPMG International. NDPPS 768607

3How behavioral economics can help corporations and government agencies



Behavioral economics and public policy

Policy makers have benefited from behavioral science in recent years by including its findings in the design of policies that impact: medical plans,9 savings rates,10 car insurance,11 and organ donations,12 to decrease internet piracy,13 and to encourage better public health behavior by the general public.

The power of default options and pre-commitmentAs Thaler explains, studies have shown that re-designing policies to include auto-enrollment increases how much people save for retirement (e.g., UK pension program) or how many people register for organ donations (e.g., Spain).14 In these real-life examples, requesting people to opt-out of the default option is an example of a nudge.

Similarly, Thaler and Benartzi have shown that savings rates could be increased by asking individuals to commit, in advance, to a series contribution increases timed to coincide with pay raises.15 This choice-architecture system, called Save More Tomorrow, reduces the inertia that is typically associated with low savings rates that were established early in employment.16 Also related to inertia behavior, studies have shown that committing to intermediate deadlines throughout a project serves as a useful nudge and improve employee performance.17

Messaging to improve public healthBehavioral economics also has important application in the public health sector. The nation’s leading health protection agency, the U.S. Centers for Disease Control and Prevention (CDC), has been investing in research on effective messaging to improve rates of prevention and screening, and to reduce unhealthy/risky behaviors, especially for minorities, underserved populations, and the youth.18 For example, the CDC has devised a text messaging service, called Text4baby, to share information with pregnant women and new moms on how to have healthy pregnancies and healthy babies.19 In another example, called SmokefreeTXT, the CDC sends out tips, advice, and encouragement to support individuals who are trying to quit smoking.20

Compared to a decade ago, many of the public health prevention and cessation programs now focus on short-term impacts in addition to outcomes that appear many years later. For example, the impact of smoking is noticeable (and impactful) only years later for smokers (i.e., increased mortality rates), and messaging around the toll of cigarette smoking has started incorporating the more tangible, immediate effects, such as dental problems and bad breath, in more recent years. Similar to the effect of delayed payment on purchase decisions when a credit card is used, many smokers tend to heavily discount the negative, long-term effects of smoking.

Motivating individualsIn a recent book, Jean Tirole, recipient of the 2014 Nobel Prize in Economic Sciences, explained how the use of an “identifiable victim” makes a difference in how we behave.21 It is well-known now that humans, as social animals, are wired to empathize more with others who share the same culture, religion, geography, or history due to evolutionary instincts. For example, even though thousands perished in Vietnam in the 1970s and in Syria more recently, what has made a significant impact on people’s perception of war were the photos of the young Vietnamese girl running naked on a street or the Syrian toddler lying dead on a Turkish beach. Research has shown that the human mind is not good at thinking about, and empathizing with, mass atrocities or suffering presented as “statistics.” Instead, we pay attention to individual, intimate stories that are dramatic.22 This is why TV commercials for non-profit organizations sometimes rely on the story of a little girl or a puppy while seeking donations rather than discussing facts about the countless people or animals that might be suffering. This gives the viewer an intimate or human connection versus an overwhelmed detachment, or numbing, due to large statistics.





Behavioral economics in the corporate world

The behavioral economic literature provides many examples of how businesses can utilize nudges to create an advantage. These strategies can assist companies with employee motivation, encouraging behaviors that are consistent with the companies’ long-term goals, and engaging in strategic pricing or messaging to increase revenues or cut costs.

Non-monetary rewards and employee empowermentOne example is the adoption of non-monetary awards to improve employees’ performance outcomes.23 Business leaders can leverage this method in the workplace by recognizing individuals for their contribution, e.g., naming someone “employee of the month.” Other studies have also shown that empowering employees by giving them more responsibility as well as control over processes (i.e., power to make decisions) has a positive impact on motivation and retention.24

Decreasing waste or costs and increasing revenuesThe hospitality industry has utilized findings from the behavioral economics literature for more than a decade by reminding hotel customers of the benefits of re-using towels and bed sheets or using water efficiently.25 These nudges clearly have no immediate economic benefit to guests, however, they impact behavior and brand perception given the advertised message of concern for and benefits to natural resources and the environment. Having sold the use of a hotel room at a price, the only way for hotels to improve their margins for a specific guest is by cutting costs. By simply reminding the guest of such benefits, hotels encourage guests to use towels (and more recently sheets) more than once, and hence attempt to limit over-consumption of a public good: water.26 More recent research has shown that the behavior can be further impacted by how the message is conveyed or what it says. Robert Cialdini recognized that informing customers that the majority of guests at the hotel recycled their towels had a larger impact than a more standard message that only asked the customers to help save the environment.27

Similar examples have shown that appropriate messaging can also improve revenues for organizations. A recent study in Lebanon investigated what would encourage people to pay their electricity bills on time and experimented with three kinds of messaging: adding a notice reminding of the late payment penalties, stating that 90% of their paid their bills on time, and including a picture of the Lebanese flag and stating that good citizens pay on time.28 Compared to a regular bill, the messages improved on time payment by 5%, 13%, and 15%, respectively.

Biases at the workplaceIn today’s polarized world, individuals tend to watch and/or follow people who share similar beliefs, especially in the media (e.g., TV, newspapers, radio, social media), which further reinforces their existing beliefs. This results in a significant barrier in broadening perspectives and understanding each other’s viewpoints. On the other hand, studies have shown that diversity in ideas and backgrounds brings significant value to companies in terms of innovation and sustainability.29 This is why many large(r) organizations invest in diversity programs and combat psychological biases in the hiring process. Individuals that are involved in hiring are put through training or are nudged to make decisions that are consistent with the company’s vision and long term strategy ensuring diversity.

Pricing of goods and servicesIn addition to diversity examples, researchers, such Ariely and colleagues, also provide examples relating to pricing of goods. Their experiments have shown that the increase in demand due to a price decrease from 14¢ to 0¢ (e.g., free) was greater than the increase in demand due to a



price decrease from 15¢ to 1¢.30 The implication of this finding was that companies can experiment with zero pricing for certain good or services, including pricing strategies that rely on free shipping for online purchases. Ariely and colleagues also argue that the effect of zero calories, zero fat, etc. (compared to negligible, non-zero amounts) may have significant impact on product demand.

A study conducted by Gneezy and Rustichini (2000) found that there can be transactions that are better not to carry “market prices.” The study involved a day care center that started imposing a fine on parents who arrived late to pick up their children. As a result, the day care experienced the opposite of what they intended to accomplish: Parents were late for pick up more often than before because the “social contract” between the parents and teachers was replaced with a market price.31 As Ariely explains, one would not pay a good friend or colleague to move furniture especially if the friend is working side by side with movers who are getting paid to complete the same task.32 Other researchers, such as Sandel (2012), have highlighted the “moral limits” of market prices and argued that not everything should have a price tag. For example, being able to buy friendships, admission to major universities, or the Nobel Prize would not serve our communal interests.33

Productivity, innovation, and ethics at the workplaceNudges are different from incentives as nudges do not significantly change the economic or financial incentives. However, financial incentives are the primary motivators that are widely used in the corporate world, and they can be tricky. There are examples of financial incentives (not nudges) leading to undesirable outcomes for companies and the overall economy.34 In the U.S. subprime mortgage crisis of 2007-2009, it became clear that economic incentives can be dangerous and lead to disasters. In years leading to the crisis, mortgage brokers, whose compensation depended on the amount of mortgages that they successfully completed, focused on their bonuses that would materialize at the end of the company fiscal year (and not on what would happen when adjustable mortgages would significantly change the market in a few years).35 In addition, in years leading to the crisis, financial traders were incentivized with fees generated from assembling financial products (i.e., mortgage-backed securities) in a given year, rather than the performance of those products and profits generated over a longer horizon. Similarly, the compensation for certain senior executives did not factor in long-term success adequately into the compensation policies. Financial incentives in the form of annual sales goals typically encourage company-wide fraud and increase the risk of company failures in the long run.



How can behavioral economics help you?

The behavioral economics field provides real-life evidence on the significant role of nudges and incentives play in our behavior in the market place, at work, or in social interactions.36 Leaders and decision makers who set public or company policies can use these findings to design strategies that encourage individuals or employees to act in a certain way.

Government agencies can encourage the public to conserve resources, contribute to public repositories (e.g., organ banks, blood donations), and engage in activities to lead healthy lives, or prepare a better financial future for themselves by using appropriate insurance tools or saving for retirement.37 Development of these policies require putting in place appropriate choice architecture that includes nuanced messaging. We do note that while public policy makers can also enact other, more effective policies, such as increasing taxes on petroleum or implementing a carbon tax to reduce emissions of greenhouse gases, behavioral approaches can provide additional supplemental support to such traditional economic policies.

Behavioral economics can assist companies in at least two important ways. First, behavioral economics can assist in the design of internal policies to encourage employees

and senior executives to do the “right” thing for the firm. Using findings from the literature or testing new approaches (either at the workplace or at a laboratory), compensation policies, benefits, and reward programs (monetary and non-monetary) can be refined to foster innovative environments that also focus on long-term, and thereby help companies attract, recruit and retain talent.38 Uptake and compliance with internal trainings (e.g., cyber security) can be improved to minimize risks for companies. Secondly, behavioral economics can assist in the design of external policies to improve revenue growth through revised pricing, payment options, shipping and return policies, or to encourage expense reductions by nudging the customers.

In either case, the design of internal polices or the design of external policies, it is important to understand the existing behaviors and incentive landscape, and then create a study to field test any new policies. Research shows that properly designed randomized control trials are key to establishing or fine tuning nudges, incentives, or messages. Such trials can take place within a company itself or at a laboratory with the appropriate setup and expertise.



Footnotes1. Thaler, R. (1999). “Mental accounting matters.” Journal of Behavioral Decision Making, 12, pp. 183-206.

2. Simon, H. (1955). “A Behavioral Model of Rational Choice.” The Quarterly Journal of Economics. 69(1), pp.99-118; Markowitz, H. (1952). “Portfolio selection.” The Journal of Finance, 7(1), pp.77-91; Strotz, R. (1955). “Myopia and Inconsistency in Dynamic Utility Maximization.” Review of Economic Studies, 23(3), pp. 165-180.

3. Stefano., D. (2009). “Psychology and Economics: Evidence from the Field.” Journal of Economic Literature, 47 (2), pp. 315–372.

4. Kahneman, D., & Tversky, A. (1979). “Prospect Theory: An Analysis of Decision under Risk.” Econometrica, 47(2), pp. 263-292.

5. Kahneman, D., Knetsch, J., & Thaler, R. (1990). “Experimental Tests of the Endowment Effect and the Coase Theorem.” Journal of Political Economy, 98 (6), pp. 1325–1348.

6. The Observer (2014, February 6). “Daniel Kahneman Changed the Way We Think About Thinking. But What Do Other Thinkers Think of Him?” The Guardian.

7. Goodwin, N., Harris, J., Nelson, J., Roach, B., & Torras, M. (2014). “Microeconomics in Context, 3rd Edition.” Routledge Taylor & Francis Group, pp. 145-154.

8. Thaler, R. & Sunstein, C. (2008). “Nudge: Improving Decisions about Health, Wealth and Happiness.” New York, NY: Penguin Books.

9. Samuelson, W. & Zeckhauser, R. (1988). “Status Quo Bias in Decision Making. Journal of Risk and Uncertainty, 1(1), pp.7-59.

10. Madrian, B., & Shea, D. (2001). “The Power of Suggestion: Inertia in 401 (k) Participation and Savings Behavior.” The Quarterly Journal of Economics, 116(4), pp.1149-1187.

11. Johnson, E., Hershey, J., Meszaros, J., & Kunreuther, H. (1993). “Framing, Probability Distortions, and Insurance Decisions.” Journal of Risk and Uncertainty, 7(1), pp.35-51.

12. Johnson, E. & Goldstein, D. (2003). “Medicine. Do Defaults Save Lives?” Science (New York, NY), 302(5649), pp.1338-1339.

13. Johnson, E., Bellman, S., & Lohse, G. (2002). “Defaults, Framing and Privacy: Why Opting in-Opting out. Marketing Letters, 13(1), pp. 5-15.

14. Chu B. (2017, October 9). “What is ‘Nudge Theory’ and Why Should We Care?” Independent, Business Analysis & Features.

15. Thaler, R. (2009, September 26). “Opting in vs. Opting Out.” The New York Times, Economic View.

16. Thaler, R., & Benartzi, S. (2004). “Save More Tomorrow™: Using Behavioral Economics to Increase Employee Saving.” Journal of Political Economy, 112(1), pp. 164–187.

17. Ariely, D. & Wertenbroch, K. (2002). “Procrastination, Deadlines, and Performance: Self-control by Precommitment.” Psychological Science, 13(3), pp. 219-224.

18. Purnell J, Thompson T, Kreuter M, McBride T. (2015, January 15). Behavioral Economics: “Nudging” Underserved Populations to Be Screened for Cancer. Vol. 12.

19. Kharbanda, E., Stockwell, M., Fo, H., & Rickert, V. (2009). “Text4Health: A Qualitative Evaluation of Parental Readiness for Text Message Immunization Reminders.” American Journal of Public Health, 99(12), pp. 2176-2178.

20. Hall, A., Cole-Lewis, H., & Bernhardt, J. (2015). “Mobile Text Messaging for Health: A Systematic Review of Reviews.” Annual Review of Public Health, 36, pp. 393-415. Head, K., Noar, S., Iannarino N., & Harrington, N. (2013). “Efficacy of Text Messaging-based Interventions for Health Promotion: A Meta-Analysis.” Soc. Sci. Med., 97, pp. 41–48.



21. Tirole, J. (2017). “Economics for the Common Good.” Princeton, NJ: Princeton University Press.

22. Resnick, B. (2017, September 5). ”A Psychologist Explains the Limits of Human Compassion.” Vox.

23. Deci, E., Koestner, R., & Ryan, M. (1999). “A Meta-analytic Review of Experiments Examining the Effects of Extrinsic Rewards on Intrinsic Motivation.” Psychological Bulletin, 125(6): 627–68. Gneezy, U., Meier, S., &. Rey-Biel, P. (2011). “When and Why Incentives (Don’t) Work to Modify Behavior.” Journal of Economic Perspectives, 25(4), 191-209.

24. Lee, A., Willis, S., & Tian, A. (2017). “Empowering leadership: A meta‐analytic examination of incremental contribution, mediation, and moderation.” Journal of Organizational Behavior, 39(3), pp. 306-325.

25. Goldstein, N., Martin, S., Cialdini, R. (2008). “Yes! 50 Scientifically Proven Ways to be Persuasive.” New York, NY: Free Press.

26. This is known as the “free rider” problem in economics when people undervalue public goods when others can freely consume the good.

27. Kallbekken, S. & Sælen, H. (2013). “‘Nudging’ Hotel Guests to Reduce Food Waste as a Win–Win Environmental Measure.” Economics Letters, 119(3), pp. 325-327. Goldstein, N., Cialdini, R., & Griskevicius, V. (2008). “A Room with a Viewpoint: Using Social Norms to Motivate Environmental Conservation in Hotels.” Journal of Consumer Research, 35, pp. 472–82

28. Stoughton, I. (2018, April 27). ”Can ‘Nudge Theory’ Change Citizens’ Behavior, Government Policy in Lebanon?” Al-Monitor.

29. Hewlett, S., Marshall, M., & Sherbin, L. (2013, December). “How Diversity Can Drive Innovation.” Harvard Business Review.

30. Shampanier, K., Mazar, N., & Ariely, D. (2007). “Zero as a Special Price: The True Value of Free Products.” Marketing Science, 26(6), pp. 742-757.

31. Gneezy, U., & Rustichini, A. (2000, January). “A Fine Is a Price.” The Journal of Legal Studies, 29(1), pp. 1-17.

32. Ariely, D. (2008). “Predictably Irrational.” Harper Perennial.

33. Sandel, M. (2012). “What Money Can’t Buy: The Moral Limits of Markets.” Farrar, Straus and Giroux.

34. Supreet, K., Kremer, M., & Mullainathan, S. (2015). “Self-Control at Work.” Journal of Political Economy, 123(6), pp. 1227-1274.

35. Story, L. (2008, December 17). “On Wall Street, Bonuses, Not Profits, Were Real.” The New York Times.

36. Thaler, R. (2017). “Behavioral Economics.” Journal of Political Economy, 125(6), pp. 1799-1805

37. Madrian, B. (2014). “Applying Insights from Behavioral Economics to Policy Design.” Annual Review of Economics, 6, pp. 663–688.

38. Martin, S., & Ferrere, A. (2017, December 4). “Building Behavioral Science Capability in Your Company.” Harvard Business Review.



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How behavioral economics can help corporations and ...the implications of neoclassical economics and proposed alternative models in order to increase the predictive power of economic